UK:
Taxing The Digital Economy

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Introduction

As part of the OECD/G20 BEPS project, and in the context of
Action 1, the Task Force on the Digital Economy considered the tax
challenges raised by the digital economy. The 2015 Action 1 BEPS
final report (the "2015 Report") and the
2018 Action 1 BEPS interim report (together, with the 2015 Report,
the "Action 1 BEPS Reports") noted that
highly digitalised business models are characterised by an
unparalleled reliance on intangibles, along with the importance of
data, user participation and their synergies with intangible
assets.

Following the publication of the Action 1 BEPS reports, the
potential tax challenges were debated – particularly in
relation to the remaining BEPS risks and the question of how taxing
rights on income generated from cross-border activities in the
digital age should be allocated among jurisdictions. No consensus
was reached regarding how to address these issues but there was a
commitment to deliver a final report in 2020, aimed at providing a
consensusbased, long-term solution.

Further to the analysis included in the Action 1 BEPS Reports,
members of the OECD/G20 Inclusive Framework on BEPS (the
"Inclusive Framework") suggested that a
consensus-based solution to the taxation of the digital economy
should be focused on the: (i) allocation of taxing rights by
modifying the rules on profit allocation and nexus; and (ii)
unresolved BEPS issues. On 31 May 2019, the OECD published a
consensus document entitled "Programme of Work to Develop
a Consensus Solution to the Tax Challenges Arising from the
Digitalisation of the Economy" (the
"Programme Report"). The Programme
Report emphasises that the way multinational corporations are taxed
will need to be reshaped in order to effectively deal with the tax
challenges arising from digitalisation. The aim is still that a
global, consensus-based solution will be agreed by the end of 2020.
The proposals outlined in the Programme Report are summarised
below.

Aside from the proposals in the Programme Report, the other BEPS
Actions also have a significant impact on the taxation of a
digitalised economy. The most relevant BEPS direct tax measures for
digitalised businesses include amendments to the permanent
establishment definition in Article 5 of the OECD Model Tax
Convention (Action 7), revisions to the OECD Transfer Pricing
Guidelines related to Article 9 of the OECD Model Tax Convention
(Actions 8–10), and guidance based on best practices for
jurisdictions intending to limit BEPS through controlled foreign
company rules (Action 3). These topics are also explored in more
detail below

The EU has also made efforts to find a solution to the tax
challenges arising from digitalisation. In March 2018, the European
Commission published two proposals to address such challenges. The
first was based on a long-term solution that proposed to tax a
digital permanent establishment, while the second was a short-term
proposal that would apply to revenues created from specific digital
activities. However, the EU Economic and Financial Affairs Council
failed to reach consensus on a way forward on an EU digital
services tax. It is unlikely that there will be an agreed approach
in the EU until at least 2020, but the new European Commission
President, Ursula von der Leyen, published a manifesto which stated
that taxation of big technology companies is a priority, and that
the EU should act alone if no global solution is reached by
2020.

Various jurisdictions have also been implementing unilateral
national measures relating to the tax challenges arising from the
digitalisation of the economy. As examples, French senators have
recently approved a temporary digital services tax, and the UK
digital services tax will take effect from April 2020. These
measures are outlined below

The Programme Report – Digitalisation of the Economy, not
the Digital Economy

One of the findings of the Action 1 BEPS Reports was that the
whole economy was digitalising and, as a result, it would be
difficult, if not impossible, to ring-fence the digital economy.
The Programme Report may therefore impact multinational
organisations which would not be immediately categorised as
"digital businesses".

The Programme Report focuses on two pillars, namely:

Pillar One – Allocation of
taxing rights: This pillar details the different technical
issues that need to be resolved to undertake a coherent and
concurrent revision of the profit allocation, and nexus rules are
detailed.

Pillar Two – Remaining BEPS
issues: This pillar describes the work to be undertaken in the
development of a global anti-base erosion ("GloBE")
proposal that would, through changes to domestic law and tax
treaties, provide jurisdictions with a right to "tax
back" where other jurisdictions have not exercised their
primary taxing rights or the payment is otherwise subject to low
levels of effective taxation

The Programme Report also discusses the work to be undertaken in
connection with an impact assessment and economic analysis of the
above proposals.

Pillar One – Allocation of Taxing Rights

The Programme Report considers the objective and scope of the
reallocation of taxing rights across jurisdictions – i.e. the
"new taxing right". The technical issues identified in
relation to the new taxing right are as follows:

different approaches to determine the
amount of profits subject to the new taxing right and the
allocation of those profits among the relevant jurisdictions;

the design of a new nexus rule that
would capture a novel concept of business presence in a market
jurisdiction reflecting the transformation of the economy, and not
constrained by a physical presence requirement; and

different instruments to ensure full
implementation and efficient administration of the new taxing
right, including the effective elimination of double taxation and
resolution of tax disputes.

Pillar Two – Remaining BEPS issues

The Programme Report recognises that the measures set out in the
BEPS package (explored in further detail below) have sought to
align taxation with value creation. However, it was also noted that
certain members of the Inclusive Framework consider that such
measures do not yet provide a comprehensive solution to the risk
that continues to arise from structures that shift profit to
entities subject to no or very low taxation.

The proposal outlined in Pillar Two seeks to address these
remaining BEPS challenges through the development of two
interrelated rules:

an income inclusion rule that would
tax the income of a foreign branch or a controlled entity if that
income was subject to tax at an effective rate that is below a
minimum rate; and

a tax on base eroding payments that
would operate by way of a denial of a deduction or imposition of
source-based taxation (including withholding tax), together with
any necessary changes to double tax treaties, for certain payments
unless that payment was subject to tax at or above a minimum
rate.

Relevant Measures of the BEPS Package

Permanent Establishments (Action 7)

The possibility to reach and interact with customers remotely
through the internet, together with the automation of some business
functions, have significantly reduced the need for local
infrastructure and personnel to perform sales and other activities
in a specific jurisdiction. The same factors potentially create an
incentive for multinationals to remotely serve customers in
multiple market jurisdictions from a single, centralised hub.

These structures can present some BEPS concerns. This is the
case when the functions allocated to the staff of the local
subsidiary under contractual arrangements (e.g. technical support,
marketing and promotion) do not correspond to the substantive
functions performed. For example, the staff of the local subsidiary
may carry out substantial negotiation with customers effectively
leading to the conclusion of sales. Provided the local subsidiary
is not formally involved in the sales of the particular products or
services of the multinational group, these trade structures can
avoid the constitution of a dependent-agent permanent establishment
in the market jurisdiction.

In response to these BEPS risks, Action 7 resulted in the
amendment of key provisions of Article 5 of the OECD Model Tax
Convention and its Commentary. The changes aim to prevent the
artificial avoidance of permanent establishment status –
which is the main treaty threshold below which the market
jurisdiction is not entitled to tax the business income of a
non-resident. In addition, the 2015 Report noted that these changes
could help mitigate some aspects of the broader direct tax
challenges regarding nexus, if widely implemented. These
expectations were primarily relevant for situations where
businesses have some degree of physical presence in a market (e.g.
to ensure that core resources are placed as close as possible to
customers) but would otherwise avoid the permanent establishment
threshold

More specifically, Action 7 provided for the amendment of the
dependent agent permanent establishment definition through changes
to Articles 5(5) and 5(6) of the OECD Model Tax Convention. The
amendments address the artificial use of commissionaire structures
and offshore rubber-stamping arrangements. Some structures common
to all sectors of the economy involved replacing local subsidiaries
traditionally acting as distributors with commissionaire
arrangements. The result was a shift of profits out of a certain
jurisdiction but without a substantive change in the functions
performed there. Other structures more specific to highly
digitalised businesses, such as the online provision of advertising
services, involved contracts substantially negotiated in a market
jurisdiction through a local subsidiary, but not formally concluded
in that jurisdiction. Instead, an automated system managed overseas
by the parent company could be responsible for the finalisation of
these contracts. Such arrangements allowed a business to avoid a
dependent agent permanent establishment under Article 5(5).

Where the recommendations of Action 7 are implemented, these
structures and arrangements would result in a permanent
establishment for the foreign parent company if the local sales
force habitually plays the principal role leading to the conclusion
of contracts in the name of the parent company (or for the transfer
of property or provision of services by the parent company), and
these contracts are routinely concluded without material
modification by the parent company

Action 7 also recommended an update of the specific activity
exemptions found in Article 5(4) of the OECD Model, according to
which a permanent establishment is deemed not to exist where a
place of business is used solely for activities that are listed in
that paragraph (e.g. the use of facilities solely for the purpose
of storage, display or delivery of goods, or for collecting
information). The proposed amendment prevents the automatic
application of these exemptions by restricting their application to
activities of a "preparatory or auxiliary" character.
This change is particularly relevant for some digitalised
activities, such as those involved in business-toconsumer online
transactions and where certain local warehousing activities,
previously considered to be merely preparatory or auxiliary in
nature, may in fact be core business activities. Under the revised
language of Article 5(4), these types of local warehousing
activities carried out by a non-resident no longer benefit from the
specific activity exemptions usually found in the permanent
establishment definition if they are not preparatory and auxiliary
in nature.

Transfer Pricing (Actions 8–10)

Business models where intangible assets are central to the
firm's profitability, such as those of highly digitalised
businesses, have in some cases involved the transfer of intangible
assets or their associated rights to entities in low-tax
jurisdictions that may have lacked the capacity to control the
assets or the associated risks. To benefit from a lower effective
tax rate at the group level, affiliates in low-tax jurisdictions
have an incentive to undervalue the intangibles (or other
hard-to-value income-producing assets) transferred to them. At the
same time, they could claim to be entitled to a large share of the
multinational group's income on the basis of their legal
ownership of the intangibles, as well as on the basis of the risks
assumed and the financing provided (i.e., cash boxes). In contrast,
affiliates operating in high-tax jurisdictions could be
contractually stripped of risk, and avoid claiming ownership of
other valuable assets.

Actions 8–10 of the BEPS Action Plan developed guidance to
minimise the instances in which BEPS would occur as a result of
these structures. In particular, the guidance seeks to address the
prevention of BEPS by moving intangibles among group members
(Action 8), the allocation of risks or excessive capital among
members of a multinational group (Action 9) and transactions which
would not occur between third parties (Action 10).

The guidance developed under BEPS Actions 8–10 was
incorporated into the OECD Transfer Pricing Guidelines in 2016 to
ensure that transfer pricing outcomes are aligned with value
creation. While the Transfer Pricing Guidelines play a major role
in shaping the transfer pricing systems of OECD and many non-OECD
jurisdictions, the effective implementation of these changes
depends on the domestic legislation and/or published administrative
practices of the relevant countries.

Controlled Foreign Company Rules (Action 3)

The 2015 BEPS Report on Action 3 provided recommendations in the
form of six building blocks, including a definition of Controlled
Foreign Company ("CFC") income which
sets out a non-exhaustive list of approaches or combination of
approaches on which CFC rules could be based. Specific
consideration is given to a number of measures that would target
income typically earned in the digital economy, such as income from
intangible property and income earned from the remote sale of
digital goods and services to which the CFC has added little or no
value. These approaches include categorical, substance and excess
profits analyses that could be applied on their own or in
combination with each other. With these approaches to CFC rules,
mobile income typically earned by highly digitalised businesses
would be subject to taxes in the jurisdiction of the ultimate
parent company. This would counter offshore structures that result
in exemption from taxation, or indefinite deferral of taxation in
the residence jurisdiction.

Domestic Responses

UK Digital Services Tax

The UK will introduce a digital services tax
("DST") from 1 April 2020 as a temporary
response to the tax challenges arising from digitalisation, with a
proposed 2% tax on UK revenues (not profits) on specific digital
businesses. Draft legislation of the DST has been included in the
Finance Bill 2019–2020. It has been suggested that the DST
will be repealed when a universal consensual approach is reached.
There is no specific legislative obligation mandating such repeal,
but the UK Government has committed to review the DST before the
end of 2025

The DST will be levied on "in-scope activities",
namely: (a) social media platforms, i.e. targeting revenues from
businesses that monetise users' engagement with the platform;
(b) search engines, i.e. targeting platforms that generate revenue
by monetising users' engagement with the platform and with
other closely integrated functions; and (c) online marketplaces,
i.e. targeting businesses which generate revenue by using an online
marketplace platform to allow users to advertise, list or sell
goods and services on such platform. Certain businesses are
specifically excluded from the definition of in-scope activities,
including the provision of financial or payment services, the sale
of own goods online and the provision of online content.

The DST focuses on the participation and engagement of users as
an important aspect of value creation for digital business models.
A key issue of the proposed approach will be how to determine
user-created value and attribute profits to user participation. The
attribution of profits will be difficult to calculate and further
guidance will be required on the mechanical rules of apportionment.
In addition, it will be challenging to allocate profits between the
UK and different jurisdictions, particularly as international rules
develop in relation to the taxation of digital
services.

The DST is designed to ensure digital businesses pay tax
reflecting the value they derive from the participation of UK
users. User participation refers to the process by which users
create value for certain types of digital businesses through their
engagement and participation. The definition of "UK user"
in the draft legislation is broad and provides that a UK user means
"any person who it is reasonable to assume – (a) in
the case of an individual, is normally in the United Kingdom, (b)
in any other case, is established in the United Kingdom".
As digital business models develop, it is expected that the range
of businesses affected by the user participation concept will
expand.

High financial thresholds are proposed for the DST. The DST will
only be payable by businesses whose global revenues from the
in-scope activities are at least £500 million. Tax will not
be levied on the first £25 million of revenue from in-scope
business activities linked to the participation of UK users.

Additionally, there is a safe harbour provision for low-margin
and loss-making businesses, which allows for a reduced rate of tax
to be paid. The thresholds are based on an expectation that the
value derived from users will be more material for large digital
businesses, which have established a significant UK user base, and
generate substantial revenues from that user base. In addition, the
thresholds are intended to ensure that the DST does not place
unreasonable burdens on small businesses.

An important factor in the implementation of the DST is the
associated EU state aid implications. Whilst the UK is preparing to
leave the EU, it is reasonable to assume that EU state aid rules
will form part of any agreement between the UK and the EU on their
future relationship. The settled case-law of the Court of Justice
of the European Union provides that, for a national measure to be
classified as state aid, the measure must confer an economic
advantage on companies which is: (i) not received under normal
market conditions; (ii) selective; (iii) granted by the State or
through State resources; and (iv) liable to distort competition and
affect trade between Member States.

The main question arising in respect of EU state aid tax cases
is the existence of selectivity. The DST would be selective on the
basis that there may be a derogation from the "reference
framework" which the DST is targeting (i.e. the group of
entities which carry out in-scope business activities). The high
financial thresholds anticipated for the DST (of £500 million
of global annual revenues from in-scope business activities, of
which at least £25 million is generated in the UK) may
constitute a derogation. Any derogation from the "reference
framework" must be justified by the nature and logic of the
national tax system. Based on the Commission's decisionmaking
practice to date, this is usually only the case if the tax paid is
somehow paid to the authorities in a different context.

However, a recent legal opinion by Advocat General Kokott in
case C–75/18 (Vodafone Magyarország Mobil
Távközlési Zrt) concluded that a special
progressive telecommunications tax imposed between 2010 and 2012 in
Hungary did not discriminate against foreignowned telecoms
companies, nor did it amount to illegal state aid under EU rules.
Advocat General Kokott reiterated that the European Court of
Justice has consistently held that "state aid" within the
meaning of Article 107(1) of the Treaty on the Functioning of the
EU requires that a selective advantage must be conferred upon the
recipient. The opinion concluded that in relation to the special
telecommunications tax, the different taxation arising from a
progressive rate did not constitute a selective advantage for
lower-turnover undertakings (and therefore did not constitute state
aid); nor can a higher-turnover undertaking rely on it in order to
evade its own tax liability.

In relation to the UK DST, it is unlikely that the beneficiaries
(i.e. the businesses that do not meet the DST thresholds) will pay
an amount corresponding to DST in some other way to the UK tax
authorities. It would follow that this derogation cannot be
justified, but the opinion in Vodafone Magyarország
Mobil Távközlési Zrt demonstrates that the
EU state aid implications of taxes such as the DST are still
evolving.

The UK has also introduced other unilateral legislative tax
measures to address the tax and BEPS challenges arising from the
digital economy, namely the Diverted Profits Tax and the Offshore
Receipts in respect of Intangible Property rules.

The diverted profits tax ("DPT") was
introduced under the Finance Act 2015 in response to the BEPS
project to prevent the erosion of the UK tax base. It is intended
to counter aggressive tax planning by international companies that
were diverting profits from the United Kingdom to reduce their UK
corporation tax liability. The DPT rate is a punitive 25% in most
cases, although higher rates can apply to specific industries

The recent "offshore receipts in respect of intangible
property" ("ORIP") rules took
effect from 6 April 2019. A charge to tax applies to
"UK-derived amounts" if, at any time in the tax year, a
person is not resident in the UK or a full treaty territory, and
such UK-derived amounts arise to them. Subject to some exemptions,
income tax is chargeable on the full quantum of the UK-derived
amounts arising in the tax year. The person liable for the tax
charge is the person receiving, or entitled to receive, the
UK-derived amounts. The new rules are designed so that a charge to
UK income tax will arise to a foreign entity where UK sales
supported by intangible property (or rights over that property) are
held by an entity in a no- or low-tax jurisdiction.

French Digital Services Tax

France has also progressed with the implementation of unilateral
measures to address the challenges of taxing the digital economy.
French senators have approved a temporary digital services tax. The
French bill sets out a 3% levy on turnover of companies with
digital business models and revenues of more than €750 million
globally and €25 million in France. The charge to tax will
broadly be imposed on revenues which include turnover from online
advertising, the sale of data for advertising, and fees drawn from
linking users on online sales platforms. The new tax is to be
retrospectively applied from early 2019, and it is expected to
raise about €400 million this year.

Many other European countries, including Italy and Spain, are in
the process of enacting unilateral measures to tax the digital
economy. It remains to be seen whether such measures will be
repealed if an international consensual position based on the
OECD's Programme Report is reached. However, the USA has been
vocal in its disapproval of national digital tax measures. In
response to the French digital services tax, the USA trade
representative, Robert Lighthizer, said that "Washington"
would conduct an investigation into France's digital services
tax, as it "unfairly targets American companies". The
investigation as to whether the French measures are discriminatory
and unreasonable to an extent where it will cause harm to US
companies was launched in July. On 26 August, a compromise was
reportedly reached between the US and France, where France
undertook to issue a tax credit accounting for the difference
between the French DST and the eventual OECD framework. Further
details should come in due course.

It is not known whether the USA will raise similar
investigations with other EU countries implementing national
digital tax measures. However, it is clear that the political
response to the taxation of the digital economy will be as relevant
as the details of any technical implementation.

US Tax Reform

The US has been consistently sceptical in relation to the
digital economy project. The reaction to the French digital
services tax emphasised the concern that the USA has in relation to
whether such national measures will negatively affect and restrict
USA commerce. The Trump administration has also repeatedly warned
of the potential dangers of inhibiting growth in this area, and are
clearly not afraid to enact unilateral measures to deal with what
they perceive as deliberate targeting of USA businesses.

Following the various amendments made to USA federal tax laws in
December 2017 under the Tax Cuts and Jobs Act, the USA also
maintains that US multinationals do not erode tax unfairly, because
the companies in question pay tax where the "value" is
created. A comprehensive summary of the changes is beyond the scope
of this chapter, but the following changes should be
highlighted:

The global intangible low-taxed
income ("GILTI") regime, whereby a 10%
or more US corporate shareholder of a CFC must include the relevant
share of net income of that foreign company in its gross income.
Such net income is an amount above a deemed fixed return to that
foreign company on its tangible assets (subject to certain
exceptions).

The foreign-derived intangible income
("FDII") regime, which provides for
corporate tax deductions against such income which is earned
directly by a US corporate. This is intended to provide an
incentive against the transfer of intangibles outside the US to
low-tax jurisdictions.

Closing Remarks

There are considerable legal and technical complexities which
multinational corporations will have to take into account with the
advent of national and international legislative measures to
address the tax challenges arising from the digitalisation of the
economy. Significantly, it should be noted that there is a
recognition that the "digital economy" cannot be
ring-fenced and as such, the various measures will impact
multinational corporations from all sectors and industries.

All these changes are taking place in the context of an
uncertain political climate. Some jurisdictions have consistently
noted opposition to tax measures designed to address the
digitalisation of the economy, and this may negatively impact
international trade. In addition, the outcome of Brexit
negotiations are unclear and this will continue to impact industry
on a UK-wide and global level.

An interesting aspect of the GloBE proposal is the income
inclusion rule, which would impose a charge to tax for
multinationals on their global income at a minimum rate, with the
aim of reducing incentives to shift profits to low-tax
jurisdictions. The concept of a minimum tax is not new in the
international tax sphere – the US GILTI regime aims to
protect the US tax base by the creation of an income inclusion
based on a broad class of CFC income. Similarly, domestic diverted
profit tax rules, for example, as implemented in the UK and
Australia, also have the effect of imposing a tax on profits that
are transferred offshore to a no- or low-tax jurisdiction. The
broad principle of such measures is to ensure that income derived
from one jurisdiction and subject to tax in a foreign jurisdiction
is taxed at least at a minimum level of tax. Whilst the rate is
intended to be punitive (in the case of the UK), both are
effectively a cost of doing business in the respective jurisdiction
where it is not possible to tax profits domestically under primary
legislation.

It is difficult to envisage how multiple domestic minimum tax
rules would interact on a global level. Issues relating to
sovereignty over tax affairs are likely to arise, as well as the
matter of how to determine tax allocation rights. A move towards a
global minimum tax, as suggested in pillar two of the GloBE
proposal, may unify the various domestic rules. However, it would
be highly complicated to achieve this from a technical and
administrative perspective.

One of the greatest challenges facing tax authorities around the
world will be aligning the gap between political rhetoric and legal
reality in order to create enforceable frameworks which offer the
clarity, certainty and coherence essential to long-term economic
growth and stability. The Programme Report is the next step in
reaching a consensual global solution to the tax challenges arising
from the digitalisation of the economy. However, the development of
unilateral national digital tax measures, together with strong
opposition from some jurisdictions to any taxation of the digital
economy, will result in a long and complex road to 2020.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

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